Ben's Un-shrinkable Balance Sheet

As he stated again clearly today, the Chairman of the Federal Reserve has
deluded himself into thinking that when the time comes, he will be able to
shrink the size of the Fed's balance sheet and reduce the monetary base with
both ease and impunity. He also has deluded himself into thinking inflation
will be easily contained.

It is very important that he does not fool you, as well.

The Fed believes low interest rates should not be the result of a high savings
rate, but instead can exist by decree, a conviction which has directly led
consumers to believe their spending can outstrip disposable income.

The result of such thinking has been a rise in household debt from 47% of
GDP in 1980 to 97% of total output in Q4 2008. As a result of this ever increasing
burden, the Fed has been forced into a series of lower lows and lower highs
on its benchmark lending rate. Keeping rates low is an attempt to make debt
service levels manageable and the consumer afloat. Problem is, this endless
pursuit of unnaturally low rates has so altered the Fed's balance sheet that
Mr. Bernanke will be hard-pressed to substantially raise rates to combat inflation
once consumer and wholesale prices begin to significantly increase.

Banana Ben Bernanke has grown the monetary base from just $842 billion in
August 2008 to a record high of $1,723 billion as of April 2009.

But it's not only the size of the balance sheet that is so daunting; it's
the makeup that's becoming truly scary.

Historically speaking, the composition of the Fed's balance sheet has been
mostly Treasuries. And the Federal Open Market Committee would typically raise
rates by selling Treasuries from its balance sheet into the market to soak
up excess liquidity. However, because of the Fed's decision to purchase up
to $1 trillion in Mortgage Backed Securities (and other unorthodox holdings),
it will not be selling highly-liquid US debt to drain reserves from banks.
Rather, it will be unwinding highly distressed MBS and packaged loans to AIG.
Not to mention the fact the Fed would have to break its promise of being a "hold-to-maturity
investor" of such assets.

Moreover, not only are the new assets on the Fed's balance sheet less liquid
but the durations of the loans are being extended. According to Bloomberg,
the Fed is contemplating extending TALF loans to buy mortgaged backed securities
to five years from three after pressure it received from lobbyists and a failed
second monthly round of auctions. That means when it finally decides it's time
to fight inflation, the Fed will find it much more difficult to reverse course.

But because of the extraordinary and unprecedented (some would say illegal)
measures Mr. Bernanke has implemented, only $505 billion of the $2 trillion
balance sheet is composed of U.S. Treasury debt. Today, most Fed assets are
derived from the alphabet soup of lending programs including $250 billion in
commercial paper, $312 billion of Central Bank liquidity swaps and $236 billion
in mortgage-backed securities.

Thus, our economy has become more addicted than ever to low interest rates.
But because bank assets will now be collecting income at record low rates,
when and if the Fed tries to raise rates it will only be able to do so on the
margin. If Bernanke raises rates substantially to fight inflation, banks will
be paying out more on deposits than they collect on their income streams. Couple
that with their already distressed balances sheets and look out!

Additionally, not only do the consumers need low rates to keep their Financial
Obligation Ratio low, but the Federal government also needs low rates
to ensure interest rates on the skyrocketing national debt can be serviced.
Our projected $1.8 trillion annual deficit stems from the belief that the
government must expand its balance sheet as the consumer begins to deleverage.
In fact, both the consumer and government need to deleverage for total
debt relief to occur, else we're just shuffling debts around and avoiding
a healthy deleveraging entirely.

In order to have viable and sustainable growth total debt levels must decrease,
savings must increase and interest rates must rise. But that would require
an extended period of negative GDP growth -- a completely untenable position
for politicians of all stripes. Ben Bernanke would like you to believe inflation
will be quiescent and he can vanquish it if it ever becomes a problem. Just
make sure you don't invest as though you believe him.

With more than 16 years of industry experience, Michael Pento acts as chief
economist for Delta Global Advisors and is a contributing writer for GreenFaucet.com.
He is a well-established specialist in the Austrian School of economic theory
and a regular guest on CNBC and other national media outlets. Mr. Pento has
worked on the floor of the N.Y.S.E. as well as serving as vice president of
investments for GunnAllen Financial immediately prior to joining Delta Global.